Monday, November 1, 2010

Price Level Targeting

As began reviewing my notes for my Weekly Commentary, I noticed that a subject which was briefly noted in the 10/22/2010 Commentary seemed to more important than just reporting comments.  It is the concept of central banks using price level targeting rather than inflation targeting as a means of boosting an economy, particularly in times of near zero rate interest.

Last week Charles Evans (Chicago Fed), as we noted in the Weekly commentary, made a speech in which he said price level targeting may be something about which the Fed should be talking.  This last week, the Bank of Canada publicly discussed it was studying price level targeting and the research has been generally positive.

In price level targeting, a central bank responds to inflation above or below its inflation target, not by adjusting the inflation target, but by policy which is designed to make up the difference in the future.  CPI growth above or below the inflation target in one year is offset in subsequent years in such a way that the price level aggregate does not move.

Last week the Atlanta Fed blogged on whether this might be a good time to adopt price level targeting.  Potential problems exist in its temporary use as a central bank transitions back to inflation targeting and the blogger sees some benefits in it being a permanent, consistent policy.  The St. Louis Fed published a paper in 2009 on price level targeting and concluded that it could successfully stabilize short-run aggregate shocks and improve welfare.  By adhering to a targeted price path, a "... central bank reduces the nominal interest rate via monetary injections to expand consumption and output."  An optimal policy would work through a liquidity effect, such as a liquidity trap.  This might also remove the volatility found in New Keynesian models in which the nominal interest rate is quite volatile.

For those who appreciate a more in-depth academic research on the subject of price level targeting, here is a paper (Adobe download) by Barnett and Engineer and discussion by Boivin.

It appears that price level targeting has been, and is, picking up steam in the debate and thinking of central banks in dealing with the current near zero interest rate environment.  This debate just appears to be emerging publicly as a serious consideration.

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